High oil prices - rich oil companies
rzwitserloot posted in politics on April 16th, 2006

Lots of people are wondering why oil companies round the world seem to make boatloads of cash when the oil price is high. It’s a simple story of risk versus reward. Read on for the details.

Oil fields which are producing oil (and gas) today have been prospected at least 10 years ago. At that time, 10+ years ago, someone somewhere made the decision to expend billions of euros/dollars to exploit the field. When such a decision is made, all that’s known is the probable cost per barrel of oil to get the oil out of the ground, along with the then current oil price.

Let’s say the raw production cost of some imaginary field prospected about 10 years ago and coming online about now, was estimated to be about 4 cents/liter (just spouting random numbers here, but for the argument it suffices). Let’s also say that the oil price 10 years ago was about 6 cents for 1 liter of crude oil. Adding up transport cost and unforseen expenses, it hardly seems worth the trouble.

Unless, of course, oil prices go up. Then it would be a sweet deal.

Then again, if the oil price goes down, the oil company loses tons of money. Usually these things come with contracts with the local country guaranteeing them a large amount of the oil at very cheap prices, so they cannot ‘back out’ and have to produce the oil at a loss, nevermind the huge initial expenses of building the oil rigs and such.

So, it’s a risk. It’s like a lottery ticket. Every oil field has a break-even point; if the world oil price is below that break even point when the oil field finally hits production, the company loses. If it’s above, company wins.

Right now the oil price is sky high. That’s good for the oil companies, they can sell the oil out of existing fields for top dollar, probably far more than their economic models ever suggested. Those oil companies that took the most ‘risk’ 10 years ago (when the oil price was quite low) are now reaping the rewards for their gamble.

They can’t very well give you the poor man paying themselves silly for your fuel needs a break. They ran a risk and need this payday.

Otherwise you get a rather bent situation: If the oil price in 10 years time is low, they lose tons of money, whereas if the oil price in 10 years is high, they get forced by silly laws to reap only limited rewards. If that were ever to become reality, no one would be dumb enough to invest in exploiting an oil field, and 10 years down the line there will be no more oil, not because the world ran out, but because no one has built new rigs.

Put another way: How many people would still invest in stocks where, if you ‘win the jackpot’, you have to hand off virtually all your gains, whereas if you lose, no one is going to help out? I wouldn’t.

So, as you can see, this ‘payday’ is the required economic incentive. It’s the natural result of the risk/reward nature of oil prospecting and exploitation (a.k.a. ‘upstream’, in the oil business jargon).